Active v passive reimagined: When imperfect is perfect

Among the most common misconceptions is finance is the idea that there is one strategy ‘to rule them all’. That is, that certain approaches to investing or portfolio construction are better than others or able to always deliver despite the prevailing market conditions.

Nowhere is this more present than in the active versus passive or value versus growth investment debate, with believers of either side seemingly unwilling to consider the combination of the two. Having managed portfolios for close to two decades, we always start with the question, why can’t we have both?

For those new to investing, defining both passive and active approaches to investing is key to understanding the important role both can play in constructing portfolios, particularly from the perspective of a retiree. Passive investing simple refers to the use of ‘index’ funds or ETFs, being those that simply track the performance of say the S&P/ASX200 or S&P500. An important caveat here would that only those funds that track a broad, large index like these truly warrant being considered being ‘passive’.

Active investing defines those investments, Australian share funds for example, that are seeking to perform better than said index. As most would appreciate, in order to have any hope of outperforming an index, the underlying investments must be significantly different.

Standard and Poor’s SPIVA reporting regularly points out the fact that the vast majority of active strategies underperform the market over the long-term. While the data and universe are not perfect, it does hide the fact that not everything about active management is focus on outright returns. Even more importantly, history is an incredibly poor guide for the future, so there is no guarantee that passive benchmarks will continue to lead the way as they have in the past.

The advantages of passive investing are straightforward, being low cost and effectively guaranteeing the average, index, return, which ensures you will never ‘miss out’. On the negative side is the fact that most benchmarks are narrowly defined and by their own definition mean that the investor can never do better than the average.

This is where I think the passive versus active debate lacks depth, particularly for retirees. In my personal experience, advising hundreds of families, both passive and active are important parts of a portfolio and more so today than ever.

They say that the journey is what matters, not the destination, the same could be said of portfolio construction. As advisers dealing with the daily emotions of investing, we need to find anyway we can to reduce the day-to-day volatility that our clients experience. Why? Because this assist in making betters investment decisions at the most challenging times.

Passive benchmarks aren’t perfect, in many cases carrying their own biases or weightings, and doing so at the wrong point of the cycle. Think technology in 2020 or 2001, they aren’t always as diversified as we think and can carry significant style basis due to the power of momentum.

Introducing actively managed strategies, but particularly those with a proven and clear ‘style’, approach or focus, alongside passive allows us to ‘improve’ a portfolio. This is from both a return and risk perspective. Ultimately, it affords a great opportunity to build ‘resilience’ into portfolios to ensure they are able to navigate even the most challenging environments.